The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, May 11, 2013

One of best indicators of genuine reform in financial sector shows no reform

In his Guardian banking blog, Joris Luyendijk interviews an equity sales director who explains how Wall Street profits from both valuation and pricing opacity when it buys or sells derivatives and why it is fighting so hard to retain opacity.

The equity sales director compares his product, which represent an investment in the real economy, with derivatives, which represent a zero-sum bet on the direction of, for example, interest rates.

Which brings me to complex derivatives. The culture of equity is so different from derivatives. We try to build relationships with clients who invest money in real companies, for the long term. Complex derivatives traders work with a far larger and diffuse pool of clients, who could decide at any point to switch from one product to the next....

With complex derivatives it's very much about here and now, as you can make money in a market that's going down as well as up. There's no direct relationship with the economic cycle.

My clients choose to deal with me for the quality of advice, the execution of their trades and the value of our research. With complex derivatives it's mostly driven by price.

Often complex derivatives are not traded on an open exchange but over the counter [OTC] – in other words, it's an agreement directly between bank and client. One reason is that OTC derivatives are usually custom-made for the client, so there's only of them in the world.

To illustrate how transparency in equity works, suppose a client places an order to buy a particular stock at careful discretion which is trading at 25. My trader goes into the market and executes it for 25.12. At the end of the day my client sees on his information terminal that the day's average price was 25.10. Did he overpay? He calls me and I go over to our trader. If it's really the trader's fault we might take the loss and give the client a better price. Otherwise we could lose our reputation and he will go elsewhere.

Now, with OTC derivatives, how does a client find out he was disadvantaged? There's no exchange. Traders and clients base prices for OTC derivatives on a number of 'Greeks' – parameters indicating levels of volatility and other derivative characteristics of the product.

It all comes down to client's ability to understand these Greeks' their sophistication. There is a huge difference between genuinely sophisticated clients and those eager to be seen as professional who actually don't grasp [all of] it.

I have heard OTC derivatives traders use the term 'rape and pillage'. That means selling a less sophisticated client a financial product carrying a high likelihood of blowing up and causing that client never to deal with you again.

"Rape and pillage" was not confined to large investors or corporations. Regular readers might recall that UK banks were involved in the mis-selling of interest rate derivatives to small companies and individuals.

A lot of regulation has come in to prevent this, but in some non-EU jurisdictions these can still be sold. Again, note the difference with equity. A client can lose money on my recommendations, but it is almost impossible to bring down the client.

"You could argue that OTC derivatives are among the best indicators of the degree of genuine reform in the financial sector.

If reform of OTC derivatives is one of the best indicators of genuine reform in the financial sector, what does reform in this area show?

One reason the crisis of 2008 got so bad was that banks had these totally opaque derivatives on their books, so nobody knew who had what.

Nobody knew which banks were solvent and which were not. So it is very clear that the reform that is needed is to bring transparency to bank derivatives books.

Since then there's been a fight to improve transparency but banks resist with all their means. Transparency correlates inversely with profitability; it has always been like that.

Given that transparency will reduce the profitability of the banks, the banks are fighting to retain opacity in the derivatives and about their exposure details (their books).

So have the banks been successful in retaining their profitability and fending off transparency in derivatives and their exposure details?

Yes.

Since OTC derivatives are one of the best indicators of genuine reform in the financial sector, the lack of transparency shows there has not been genuine reform in the financial sector.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.